Profitability ratios can help you analyse your company’s ability to generate earnings, in relation to sales, assets and equity. In addition to giving you valuable information on profits and cash flows, these metrics highlight how effectively your company is being managed. Stuart Leung, SEO Manager, Salesforce.com, shares his practical analysis…
To stay profitable and competitive in a crowded business landscape, organisations must constantly try to maximise earnings and minimise expenses. However, accurately determining how well organisational assets are being used to generate profits can be a formidable task.
That’s where profitability ratios come in – a group of financial metrics that organisations can use to become more efficient and profitable. To that end, here’s a look at several key profitability ratios and what organisations can do to improve them.
How profitable is a company in selling its inventory or merchandise? The gross margin ratio provides an answer by comparing the gross margin of a company to net sales.
Another way to think of the gross margin ratio is the percentage mark-up on merchandise from its cost—calculated by dividing gross profit dollars by net sales dollars. For example, a company with net sales of US$600,000 over a given period and a cost of goods sold of US$400,000 would have a gross profit of US$200,000 (a figure reached by subtracting the latter amount from the former). Dividing the gross profit (US$200,000) by the net sales (US$600,000) yields a gross margin ratio of 25 per cent. The larger this percentage, the more profitable the company should be.
Of course, understanding the percentage of profitability in a company is only valuable if an organisation can then use that data to affect positive change. Thankfully, there are a number of ways to increase the gross margin ratio. For example, building brand value through effective marketing in order to convince customers to pay more for products, even while acquisition costs stay the same, can be a very successful approach.
An added benefit of upping the perceived value of a brand is higher customer retention, which also improves the bottom line.
Most businesses rely on sales to generate revenue. Unfortunately, 67 per cent of all sales people fall short of reaching their quotas. The development of a more-efficient sales process and a higher-quality sales force can help organisations increase overall sales effectiveness.
Better internal communications within the sales department is a good start and can be highly beneficial, as it allows for a more efficient use of time and resources. When employees and leaders across different levels and departments within the organisation communicate effectively, many potential problems may be averted.
Advanced CRM tools such as the Salesforce’s Community Cloud provide a platform for members of an organisation – as well as customers, partners, and others – to form online communities, and interact, troubleshoot, and gain access to data. In addition to facilitating clear communication within a company, these CRM tools also help increase customer satisfaction.
The use of analytics tools to gain a better picture of each step in the sales funnel, as well as promote B2C and B2B lead generation and qualification, is also a powerful driver of higher gross margin ratios, as companies that excel at lead nurturing generate 50 per cent more sales ready leads at 33 per cent lower cost.
The operating margin ratio takes gross profit margin one step further by factoring in overheads—such as selling, administrative expenses, and depreciation—along with the cost of goods sold. As a result, the operating margin directly reflects the income associated with the company’s core business and operations. Think of it as a measure of the money flowing into a company from sales, and flowing out for day-to-day expenses.
A high operating margin ratio is a strong indicator that the business is being run efficiently, which translates into higher profitability overall.
Organisations looking to increase operating margins should focus on finding ways to either spend less money by reducing operating expenses, or bring in more money by increasing sales. Owning equipment instead of leasing or renting, cutting out unnecessary expenses, and possibly downsizing are all proven ways for companies to spend less. However, in the push to increase operating margins, businesses should be wary of potential dangers of cutting costs.
Purchased equipment often requires a sizable initial expense, and may result in a company getting ‘locked’ into technology that quickly becomes obsolete. Downsizing may result in lower employee morale among those who retain their jobs. Increasing sales, however, is doubly beneficial, as more sales bring in more revenue and achieve efficiencies through economies of scale, which can translate into lower production costs and supplier discounts.
Profit margin (or net profit margin) is a ratio that takes a simple and straightforward approach to evaluating a company’s profitability. Along with incorporating all the elements used to calculate operating margin, profit margin ratio also factors in non-operating income, interest expense, and income taxes.
While the simplicity of this ratio allows organisations to evaluate how much of every dollar in sales is actually retained as earnings, the ratio includes expenses and income that aren’t directly related to the company’s core business (making profit margin more of a second-tier financial metric). Still, it’s very useful for companies looking to see how they stack up with others in their industry. A higher profit margin for a company means it’s more lucrative and has a better handle on costs than competitors. When it comes to finding ways to improve profit margins, the commercial airline industry serves as a good case study.
Faced with shrinking revenues in a highly competitive arena, JetBlue is taking a cue from its competitors. In the past, JetBlue hasn’t charged passengers to check second bags. But now the popular carrier is seriously considering it, as other carriers that charge for the first bag have enjoyed significant increases in revenue. In addition, JetBlue plans on packing more seats on its planes to increase per-plane profit while all other factors remain the same.
Return on Assets
A company’s annual income is derived from business assets in use throughout the year, including any assets added on during the year. Like ROI, return on assets – the ratio of net income over total assets – is a good measure of a management’s ability to use corporate assets to generate profit. The higher a company’s return on assets, the more money it can make with less equipment, inventory, etc.
To improve return on assets, companies need to either increase net income or decrease total assets. Ways to do that include raising the price of products and services without dropping demand, boosting sales volume (without increasing asset base) through effective marketing, better sales force training, a more efficient sales process, and implementing a “lean” business model—which may include outsourcing non-vital business functions to third parties.
Given today’s competitive business landscape, companies need to raise all contributors to profitability from levels of sufficiency to efficiency. By focusing on the above key financial ratios and the concrete ways to achieve greater profitability, such as pricing, reducing waste and costs, boosting sales volume, and improving customer service and customer retention, companies stand a much better chance of reaching long-term profitability and sustainability.
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Rushika Bhatia Editor
Rushika Bhatia is one of the region’s leading commentators on business and current affairs issues. She is the Editor of SME Advisor magazine - the flagship title of CPI Business. She is passionate about infographics – with special emphasis on data, research and statistics. Rushika has a Bachelor’s Degree from Indiana University, USA and is also CIMA qualified.